Monday, 29 August 2011

We can’t all deleverage at the same time

We can’t all deleverage at the same time. That would be equivalent to everyone moving to the same spot in a sinking ship. It would capsize immediately. To see why, imagine this nightmare scenario: everywhere and everybody – banks, firms, governments and families – think that they are overleveraged (i.e. is excessively in debt) and decide to reduce debt (deleverage) simultaneously. Regardless of whether they are right or wrong about their excessive level of debt (in a previous post we explain why this is difficult to define); the simultaneous deleveraging could start the following fatal spiral.

Banks reduced excessive leverage by not renewing their lending facilities to firms; these add misery to injury and reduce further their leverage by firing workers and trying to sell assets. Braced with lower tax revenues and higher calls for unemployment insurance, governments answer by reducing public debt through higher taxes and massive cuts in spending; which reduce the revenue streams of banks, firms and families. Families, affected by higher unemployment, loss of revenues and fearing the future, decide also to deleverage by saving more or defaulting on their loans and by massive cuts in spending. This would reduce further the revenues of banks, firms and governments. Thus, to pursue their debt reducing objectives all would initiate a new round of cuts. This would cause a downward spiral of spending cuts that would stop only after the economy was brought to a complete halt and widespread defaults.

Wait, there must exist some break point on this spiral. After all, debts are owed to someone and those receiving the debt repayments must use their surplus money. Yes, but what if, fearing that same spiral, they decide to hoard it by holding cash, exchanging it for some remote currency (e.g. the Swiss Franc) or buying some relic from the past (e.g. gold). The first, if not offset by the Central Bank, would cause a major liquidity crisis accelerating the depression. The other two may lead to absurd bubbles whose anticipated bust would hang on the heads of enterprising people. So, not much hope here.

What if there is somewhere an unleveraged entity willing to finance an orderly sequence of deleveraging through saving and inflation? To a large extent that was the situation at the end of World War II, when the US played that role. Can’t China and other emerging nations play that role now? Probably not, because they do not have the economic size needed to face a much bigger problem. Moreover, by accepting a rescue from a dictatorship, the Western democratic nations would risk losing their freedom.

Indeed, despite some double counting, the following table shows that the net international investment position of the Western countries is less than 3% of their GDP, largely because of the high level of savings in Japan. Yet, Japan has the largest government debt as a percentage of GDP (226%).

Unfortunately, a deleveraging spiral may start without all countries being overleveraged. A debt crisis in one sector (e.g. the Government) may easily infect the remaining or be started off by a generalized downgrade by the rating agencies. In fact, some fear that the leading Western nations (US, European Union and Japan) may be in the brink of getting into such a depression spiral started by deleveraging in the sovereign debt sector. So they desperately need to find an alternative solution.

First, they must plug once and for all the holes emerging in the weaker economies of the Euro Area. Second, they must mobilize the spending power of the few remaining sectors with borrowing capacity. Finally, and most importantly, they must acknowledge that at least one entity must be allowed to continue to increase its leverage while the others deleverage.

Here the obvious choice must be the Government (except in Japan), due to its policy powers, but mostly because it is the only one that can borrow with very long maturities.

Thus, although we live in a peacetime period, sovereign debt limits in the US and Europe can be increased to levels close to those observed at the end of wars. That is, countries with national debts around 60% of GDP could borrow close to a 100%, while those already above the 100% should be allowed to borrow up to 180% of GDP.

The process, relying on multilateral facilities, should be sequential with an agreed calendar and coordinated at the level of the G3 group of countries (not the G20, which should only have a consultative role).

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